Midland Energy Resources Cost of Capital
Midland Energy Resources, Inc. is a global energy company with its operations in three divisions – Oil and gas exploration, Refining and Marketing and Petrochemicals. The company has been there for 120 years and in 2007 had more than 80,000 employees. It has been a very profitable company with reported operating revenue of $248. 5 billion and operating income of $42. 2 billion in 2006. The primary goals of Midland’s financial strategy are to fund overseas growth, invest in value-creating project, achieve an optimal capital strategy and repurchase undervalued shares.
To accomplish all these goals the company has asked Janet Mortensen, Vice President of finance for Midland energy resources, to calculate the weighted average cost of capital (WACC) for the company as a whole. Formula: WACC = rd (D/V) (1-t) + re (E/V) Where, rd = cost of debt; re= cost of equity; D = Market value of debt; E= Market value of equity; V= Market Value of the company (D+E); t= Tax rate. Risk Free Rate, rf: Midland’s borrowing capacity is typically depended on its energy reserves and long-term assets. Considering its assets long-term valuation a 1-year risk free rate seemed unreasonable.
Midland Energy Resources Cost of Capital Essay Example
Furthermore there is a high correlation of Midland’s stock price with changes in energy prices, which required periodic re-evaluation of its borrowing capacity. A 30-year Treasury bond rate also doesn’t quite seem to justify its unpredictable nature. For Exploration and Production (E&P) and Refining and Marketing (R&M) a 30 year maturity T-Bond can be used as those divisions tended to focus on longer term projects. But a division like Petrochemicals tends to focus on shorter-term projects. So, 1 year T-bond will be applicable for this.
So, for overall, Midland Energy Resource we have decided to take 10-year risk free rate, which is 4. 66%. Equity Market Risk Premium (EMRP): In 2006, Midland used an equity market risk premium of 5%, but higher EMRP’s -6% to 6. 5% – had been used by Midland at various times in the past. Midland adopted its current estimate of 5. 0% after a review of recent research and in consultation with its professional advisors – primarily its bankers and auditors – as well as Wall Street analysts covering the industry. So, we also decided to use 5%. Tax rate, t: In 2006, Midland’s income before tax was $30,447 million.
They paid $11,747 million of taxes. So, the tax rate was 11,747/30447 = 38. 6%. We have decided to use 39% as a round number for tax rate. Cost of Debt, rd: The cost of debt is calculated as the yield to maturity offered by the U. S government Treasury bonds plus the risk premium interest rate that lenders demand for taking the risk of lending money to the company. Midland’s cost of debt is equal to the consolidated spread to treasury of 1. 62% in addition to the 10-year rate of the U. S Treasury bond.